There are only three
real solutions to Social Security's rapidly approaching fiscal
problems: raise taxes, reduce spending, or make the current payroll
taxes work harder by investing them through some form of personal
retirement account (PRA).

Establishing PRAs is
the only solution that will also give future retirees the option to
receive an improved standard of living in retirement. These
accounts would give them more control over how to structure their
income and allow them to build a nest egg that could be used for
emergencies during retirement, used to start a business, or
left to their families. However, establishing PRAs will be
complex and-as experience from other countries shows- will require
careful planning.

How can such a reform
be achieved? Whatever emerges from Congress and is signed into law
will not be identical to any one proposal presented to Congress. It
may contain key elements from a number of specific proposals.
As this process unfolds, however, it is critical that lawmakers
committed to reform maintain a clear picture in their minds of the
framework needed for reform and what variants of basic ideas can be
accommodated without undermining the basic goals of
reform.

What should such a
framework look like? What choices within this framework would still
achieve the goals of reform? This paper lays out a practical
framework for establishing a successful PRA program that will
improve the retirement incomes of future retirees and reduce the
huge unfunded liability of the current Social Security
system.

A Framework for
Reform

A practical framework
for establishing a successful PRA program would:

Create an account
structure that uses a portion of existing payroll taxes and
allows workers of all income levels an opportunity to build family
nest eggs. The PRAs would be
voluntary and would not affect current retirees or those close to
retirement in any way. The Social Security PRAs should be funded by
directing a portion of their Social Security retirement taxes into
their PRAs. About 5 percent of income would be best, but the
directed portion should not be less than 2 percent or more than 10
percent.

Create a simple,
low-cost administrative structure for the accounts that uses the
current payroll tax system and professional investment
managers. Using the existing
payroll tax system would reduce costs. Rather than having the
government invest PRA money, the agency overseeing the accounts
should contract out fund management to professional fund
managers.

Create a carefully
controlled set of investment options that includes an
appropriate default option. Initially, workers
would be allowed to put their PRA contributions into any one of
three balanced and diversified mixes of stock index funds,
government bonds, and similar pension-grade
investments.

Adjust current Social
Security benefits to a more sustainable level. Despite promises from
both the left and the right to pay promised benefits in full,
this is simply not realistic. While current retirees and those
close to retirement should receive every cent that they are
due, future benefit promises must be scaled back to more realistic
levels.

Create a realistic plan
for paying the general revenue cost of establishing a PRA
system. The necessary general
revenue will have to come from some combination of borrowing
additional money, collecting additional taxes, reducing other
government spending, and reducing Social Security benefits. While
some Representatives and Senators will be tempted to cover Social
Security's deficits with higher taxes, this is the wrong approach.
The necessary amounts are so large that such a tax increase
would consume enough resources to stall economic
growth.

Create a system that
allows workers flexibility in structuring their retirement
benefits while ensuring that they receive an adequate monthly
benefit. A PRA plan should
require all retirees to use some of that money to purchase an
annuity that would guarantee at least a minimal level of income for
life, including an adjustment for inflation. This requirement would
protect taxpayers against retirees who could otherwise spent their
entire PRAs and then expect some form of government handout to
meet their monthly expenses.

The Challenges Facing
Today's Social Security

According to the
Congressional Budget Office, approximately 80 percent of
Americans pay more in payroll taxes than in federal income taxes.[1]
Today's Social Security system provides retirees with a stable
retirement income and a level of protection against poverty
caused by disability or the premature death of a parent or
spouse.

Despite the presence of
private methods to invest for retirement, in 2001 approximately
one-third of retirees on Social Security received at least 90
percent of their income from that program. Almost two-thirds of
them depended on Social Security for at least 50 percent of their
retirement income.[2] These workers would likely benefit the most
from a PRA that allowed them to invest some of their payroll
taxes.

Today's Social Security
faces four major problems that threaten its ability to provide
future retirees the same type of retirement security that was
available to their parents and grandparents:

Massive future
deficits. In less than 15 years
(approximately 2018), Social Security's retirement program
will begin to spend more per year in benefits than it receives in
taxes. Within a few years, these deficits will exceed $100
billion annually and will continue to grow from there. Social
Security has a "trust fund" drawer full of government bonds, which
are nothing more than pledges to use ever-larger amounts of general
revenue taxes to pay benefits. When it comes time to repay those
bonds, the federal government will have to reduce spending on other
government programs, increase taxes, and/or increase government
borrowing. By about 2042, the drawer of paper promises will be
empty. From that point forward, the benefits paid to retirees will
be cut-first by 27 percent and then by ever-greater amounts-as
Social Security's deficits grow larger.

The inability of
workers to build a nest egg and the lack of property rights to
their benefits. Today's Social Security
not only fails to provide workers with any way to build a
family nest egg, but also actually discourages savings by
absorbing a large proportion of earnings that moderate-income and
low-income workers could otherwise use to save for retirement or
other purposes.[3] In addition, workers have no property right
to their benefits. This is a key flaw because, even if the
program was reformed to allow workers to build a family nest
egg, without property rights the government could reclaim that
money at any time. Two Supreme Court cases dealing with Social
Security confirm this lack of property rights.[4] The decisions in
both cases explicitly state that workers have no level of ownership
of their Social Security benefits.

A poor rate of return
on their payroll taxes. Younger and
lower-income workers will receive relatively little in benefits for
their Social Security taxes because they will have to pay
substantially higher taxes than older workers do. A
25-year-old male with an average income is predicted to
receive a -0.82 percent rate of return on his Social Security
taxes. In other words, he will pay more into the system in taxes
than he will receive back in benefits. The situation is even worse
for low-income workers. A 25-year-old male living in a low-income
section of New York City would receive a -4.46 percent rate of
return on his Social Security taxes.[5]

No choice of how
benefits are paid. Under the current
inflexible system, all workers receive a monthly payment that
starts when they retire and ends when they die or when their
spouses or dependents die. This one-size-fits-all approach
especially hurts the one-fifth of white males and the one-third of
African-American males who die between the ages of 50 and 70.[6] These
workers face the prospect of paying a lifetime of Social
Security taxes in return for little or no retirement benefits. A
more flexible system would give them the comfort of knowing
that at least a portion of their taxes will go to their families in
the form of a nest egg.

Goals for Fixing Social
Security

To focus the reform
debate on real solutions, it makes sense to develop several
overarching goals to ensure that all of Social Security's problems
are fixed both for the next few years and for the foreseeable
future. An unfocused debate would fix only certain problems while
leaving the others to worsen. An incomplete or poorly considered
reform would result in the same debate being replayed in a few
years in an atmosphere in which there will be even less flexibility
to resolve the system's financial crisis.

We therefore owe it to
our children and grandchildren to get reform right the first
time. When reforming Social Security, policymakers should keep the
following goals in mind:

Goal #1: Improve the
retirement income of future retirees without reducing the benefits
of current retirees or those who are close to
retirement.

Social Security reform
should not reduce the benefits of current retirees or those who are
close to retirement. These workers have spent a lifetime paying
their payroll taxes in exchange for the promise that they will
receive a set level of benefits. Americans have a moral
obligation to pay them every cent that has been promised, including
an annual cost-of-living increase to replace the loss of buying
power caused by inflation.

At the same time,
younger workers should have the opportunity to receive a higher
retirement income than the current system will be able to pay by
the time they can retire. Workers retiring after about 2042 can
really expect to receive only about 73 percent or less of what they
are being promised. A reasonable reform would allow them the
opportunity to improve their retirement incomes by investing a
portion of their current payroll taxes.

Goal #2: Add voluntary
PRAs that include a savings/nest egg component to the current
system.

In the future, Social
Security retirement benefits should come from both the current
government-paid program, which would become Social Security
Part A, and from the individual worker's PRA, which will be known
as Social Security Part B. Workers should be able to choose whether
to rely totally on Part A or to invest a portion of their
retirement taxes through Part B. As shown by the experience of over
25 countries, including the United Kingdom, Sweden, Switzerland,
and Australia, PRAs can help workers to improve their
retirement incomes without unreasonable risks.

At the same time,
simply establishing PRAs is not sufficient. Social Security Part B
should be designed to give workers more control over how their
retirement income is structured by allowing them to build nest
eggs. Upon retirement, these nest eggs could be used to increase
monthly income, reserved for an emergency, or left to family
members. In the event that the worker dies before retirement, these
nest eggs would remain a part of the worker's estate and could be
passed on to heirs.

Goal #3: Reduce the
unfunded burden that today's Social Security system will impose on
future generations.

Social Security has
promised future generations far more in retirement benefits than
its current funding sources will be able to pay. Meeting these
obligations without reforms will force our children and
grandchildren to pay crushing payroll taxes, which will sharply
reduce their standard of living. In addition, because payroll taxes
are essentially a levy on jobs, substantial payroll tax increases
will reduce economic growth and kill jobs.

This also applies to
the amount of additional general revenue money that will be
required to pay full benefits under a PRA plan. Even though this
cost will be substantially lower than the amount that would be
required to pay full benefits under the current system, reformers
should not repeat the mistake of trying to build political support
today by pushing substantial costs onto future
generations.

A sensible reform would
reduce the benefits promised to younger workers to more reasonable
levels while also giving them the time and tools necessary to make
up the difference through investment earnings. Continuing to
promise those who are a long way from retirement more than Social
Security can realistically deliver only makes the system unstable
by pushing the burden of paying for it onto future
generations.

Six Steps to Creating a
Workable PRA System

Step #1: Create an
account structure that uses a portion of existing payroll taxes and
allows workers of all income levels an opportunity to build
family nest eggs.

Who Could
Participate? PRAs would be
voluntary. Younger workers would have the opportunity
either to open a PRA or to continue in the current system and
accept whatever benefits it could afford to pay at their
retirement. Because the PRA plan would allow the worker the
opportunity to receive higher retirement benefits than the
government-paid system could afford to pay, workers would
automatically have a PRA unless they opt out of the system.[7] Opting
out could be accomplished by filing a simple form with the
Social Security Administration or even by checking a box on the
workers' income tax forms.

Current Retirees Would
Not Be Affected. No system of PRAs would
affect current retirees in any way. They would receive every cent
that they have been promised, including an annual cost-of-living
increase. This would also be true for workers nearing
retirement. Because they would not have the ability to alter their
retirement savings significantly, all workers above a certain
age (which would be determined in part by the structure of the
specific PRA plan) would also receive their full promised Social
Security retirement benefits, including cost-of-living increases.
Depending on the plan, this age could be as high as 60 or as low as
in the 40s. In most cases, it would reflect the worker's age on the
date that the plan goes into effect, even if it is announced well
before then.

Workers Would Own Their
Accounts. A key feature of this
system is that workers would own their accounts. Every cent that
goes into the PRA would benefit either the worker or the worker's
family. Although the worker would not be able to use this money
until retirement, the fact that he or she owns it and is able to
see how the money is being used would help to prevent future
Congresses from attempting to seize retirement money for some
politically motivated purpose. In addition, if the worker dies
before retirement, amounts left in the PRA after providing for any
survivors' benefits would go into the worker's estate and could be
left to the family, a church, or any other worthy cause designated
by the worker.

Where Would the Money
Come From? The money that would go
into Social Security PRAs should come from directing a portion of
workers' Social Security retirement taxes. Because money in these
PRAs would earn higher returns than the current government-paid
Social Security benefit, this structure would help the worker to
get more for his or her taxes.

Hypothetically, PRAs
could be funded by higher payroll taxes, mandatory additional
savings, or even some form of general revenue transfer. It would
also be possible to find the money for PRAs through some
combination of these methods, either with or without directing some
of the existing payroll tax. However, every method except
using some of the existing Social Security retirement taxes
essentially boils down to a tax increase and would require
taxpayers to pay more for their Social Security benefits. This, in
turn, would reduce the already low return that workers get for
their retirement taxes to an even lower amount. In addition, higher
payroll taxes would negatively affect the economy by reducing
employment and curbing economic growth.

How Large Would the
Accounts Be? Currently, workers
pay a total of 10.6 percent of their income for Social Security
retirement and survivors' benefits.[8] To fund PRAs that have a
chance of paying for substantial portions of workers'
retirement benefits, an amount of payroll taxes equal to about
5 percent of income should be deposited into their PRAs.

In theory, PRAs could
be any size, ranging from about 2 percent of earnings to as much as
10 percent. However, in order to have any effect on future
liabilities, these accounts should not be any smaller than 2
percent of income.

Because larger
accounts-about 5 percent of income or more-create useable pools of
money much faster than smaller ones, they are more likely to be
able to pay for a higher proportion of the owners' Social Security
benefits. This would sharply reduce costs for future generations
and make it more likely that the reformed system could pay benefits
closer to the level promised by today's system. The higher
shorter-run general revenue requirements of establishing a
system of larger personal retirement accounts would be more than
offset by the reduction in the system's unfunded
liability.

However, larger
accounts will also require larger amounts of general revenue to
make up the difference between the remainder of Social
Security's payroll taxes and what the program owes in
benefits. While the necessary general revenue transfers would
be less than under the current Social Security system, they
would still be significant.[9] As a result, if the additional general
revenue costs of a system of larger PRAs is beyond Congress's
ability to finance for now, it may choose to establish smaller
PRAs.

"Progressive"
Accounts. Today's program
recognizes that low-income workers are much more likely than
those with higher incomes to have no retirement benefits other than
Social Security. As a result, those workers are currently given a
higher monthly benefit relative to their earnings.[10] A PRA system
could duplicate or exceed the current program's progressivity
by allowing low-income workers to save a higher proportion of their
payroll taxes. For instance, a minimum-wage worker might be
allowed to save up to 6 percent to 8 percent of income each
year, while the highest-income worker could save only about 2
percent to 4 percent. Because the amount of each worker's
contributions would be calculated by the Department of the
Treasury based on the worker's tax forms, it would be no harder for
the Treasury to use this sliding scale than it would be to
administer a system under which everyone contributes the same
proportion of his or her salary.

There are two other
benefits to this approach. First, because younger workers almost
always start in fairly low-income jobs, it would allow them to
build up account balances more rapidly than a flat contribution
level would. These balances would grow throughout the remainder of
the workers' careers. Second, a sliding scale that allows
lower-income workers to place a higher proportion of their incomes
in a PRA should help to lower administrative fees by reducing the
number of very small annual contributions that the system would
need to handle.

Another feature that
could be added to a PRA system would be to give workers the option
to make additional contributions up to a certain amount. Ideally,
these additional contributions would receive the same tax treatment
as contributions to individual retirement accounts (IRAs) and
other retirement savings plans currently receive.

Building Nest Eggs for
the Future. A well-designed
retirement system includes three elements: regular monthly
retirement income, survivors' and dependents' insurance, and
the ability to save. Today's Social Security system provides a
stable level of retirement income and provides benefits
for survivors and dependents, but it does not allow workers to
accumulate savings to fulfill their own retirement goals or to pass
on to their heirs. Workers should be able to use Social Security to
build a cash nest egg that can be used to increase their retirement
income or to build a better economic future for their
families.

A PRA system should be
designed to allow every worker at every income level the
opportunity to leave a nest egg to his or her family. Today, less
than 13 percent of all households making less than $20,000
have ever received inheritances.[11] Only among families making
over $100,000 does the frequency of inheritance exceed
25 percent. However, a properly designed PRA system would
not limit inheritances to the rich. Everyone would be able to use
his or her PRA to build a cash nest egg that could become an
inheritance.[12]

Step #2: Create a
simple, low-cost administrative structure for the accounts
that uses the current payroll tax system and professional
investment managers.

A simple and effective
administrative structure is essential to the success of a PRA
system. Probably the simplest and cheapest structure would be
to use the existing payroll tax system. Under today's Social
Security, the employer collects and sends to the Treasury
Department both the payroll taxes that are withheld from an
employee's check and those that are the responsibility of the
employer. The payroll tax money from all of the firm's employees is
combined with income taxes withheld from their paychecks and sent
to the Treasury. The money collected is allocated annually to
individual workers' earnings records after worker income tax
records have been received.

Adapting this existing
administrative structure to a PRA system would be easier to
implement than other options. Under a PRA system, the employer
would continue to forward to the Treasury Department one
regular check containing payroll and income taxes for all of the
firm's employees. The Treasury would continue to use its existing
formula to estimate the amount of receipts that should be credited
to Social Security and to reconcile this amount annually with
actual tax receipts.

Once the Treasury
determines the amount to be credited to Social Security, it would
estimate the portion that would go to PRAs and forward that amount
to a holding fund managed by professionals who would invest
the amount in money market instruments until it is credited to
individual taxpayers' accounts. The money would go to
individual workers' accounts upon receipt of their tax
information. It would then be invested in the default fund, except
for workers who have selected (on their income tax forms) one of
the other investment options, in which cases it would be invested
accordingly.[13]

Using Professional Fund
Managers. Rather that having the
government trying to invest PRA money, the agency overseeing the
accounts (which could be the Department of the Treasury, the Social
Security Administration, or an independent board) should contract
out fund management to professional fund managers. This investment
management system is currently used by the Federal Employees
Thrift Investment Board, which administers the Thrift Savings
Plan, a part of the retirement system for federal
employees.

Under this system,
management of the specific investment pools would be contracted out
to professional fund managers, who would bid for the right to
manage an asset pool of a certain size for a specified period of
time. The manager could invest the money only as directed by the
agency. The agency would also contract out to investor services
such tasks as issuing regular statements of individual
accounts, answering account questions, and handling transfers from
one investment option to another.

Advantages of this
Administrative Structure. Building on existing
structures and contracting out investment management and services
should keep costs to the lowest level possible. In addition,
employers would not have to change their current payroll practices.
Using one central government entity to receive PRA funds also means
that employers would not bear the cost of writing individual
checks or arranging for individual fund transfers for each
employee. In addition, this method allows the PRA contributions of
workers who have multiple jobs to be based on their total income
without placing any additional burden on either the worker or the
employers.

From a worker's
standpoint, this should be the lowest-cost structure available. In
addition, because workers' PRA contributions would be
distributed to their chosen investment plans only after their
tax information has been received, workers with several jobs during
a year should see contributions based on their total annual
incomes.

Step #3: Create a
carefully controlled set of investment options that includes an
appropriate default option.

The investment options
available to PRA owners should be simple and easily understood.
While an increasing number of Americans are investing their money
for a wide variety of purposes, a voluntary PRA system would
bring in millions of new investors who may not have any previous
investment experience. In addition, experience from both the
401(k) retirement plans and federal employees' Thrift Savings Plan
shows that costs are far lower if the plan starts with only a few
investment options and then adds more once the plan is fully
established.

Carefully Controlled
Investment Options. All investment options
available under a PRA plan should be limited to a diversified
portfolio composed of stock index funds, government bonds, and
similar assets. Even if they so desire, workers would not be
allowed to invest in speculative areas such as technology stocks or
to choose specific stocks or bonds. Money in a PRA is intended to
help to finance a worker's retirement security, not to be risked on
speculative investments with the hope that taxpayers will support
the worker if the investment fails.

Initially, workers
would be allowed to put their PRA contributions into any one of
three balanced and diversified mixes of stock index funds,
government bonds, and similar pension-grade investments.
Although the exact mix of assets would be determined by the central
administrative agency, one fund might consist of 60 percent stock
index funds and 40 percent government bonds, while another might be
60 percent government bonds and 40 percent stock index
funds.

The third fund, which
would also act as the default fund for workers who failed to make a
choice, would be a lifestyle fund. These are funds in which the
asset mix changes with the age of the worker. Younger workers would
be invested fairly heavily in stock index funds, but as they age,
their funds would automatically shift gradually toward a portfolio
that includes a substantial proportion of bonds and other
fixed-interest investments. This is designed to allow the
portfolios of workers who are far from retirement to grow with the
economy and to allow older workers to lock in that growth by making
their portfolios predominantly lower-risk investments.

Workers would be
allowed to change from one investment fund to another either
annually (by indicating their choice on the income tax form) or at
other specified times (by completing a form on the Internet). They
would also receive quarterly statements showing the balance in
their accounts. As with today's Social Security, PRA accounts are
intended strictly for retirement purposes, and no early withdrawals
would be allowed for any reason.

Keeping Fees
Low. Under a successful PRA
plan, all investments must be approved by the central
administrative agency as being appropriate for this level of
retirement investment. That agency would also ensure that
administrative costs are kept as low as possible by awarding
contracts to manage investment pools through competitive bidding
and through direct negotiation with professional funds
managers.

Research by State
Street Global Investors[14] shows that administrative costs are lower
if workers put all their money in one diversified pool of
assets rather than attempting to diversify their portfolio by
dividing it among several types of assets. For example, a worker
who puts all of his or her money in one fund consisting of 50
percent stock index funds and 50 percent government bonds would
earn the same as a worker who places half of his or her money in a
government bond fund and half in a separate stock index fund.
However, the first worker would incur significantly lower
administrative costs.

Additional Choices for
Larger Accounts. Once a worker's PRA
account reaches a certain size threshold (determined by the central
administrative agency), he or she would have the option to move its
management to another investment manager if that manager offered
better service or potentially higher returns. However, only
investment managers who had meet strict asset and management
quality tests would be allowed to receive these accounts, and the
managers would be sharply limited in the types of investments they
could offer. In the event that the worker is dissatisfied with
either the fees or the returns from these individually managed
accounts, he or she could switch back to the centrally managed
funds at any time.

Step #4: Adjust Social
Security Part A benefits to a more sustainable
level.

The sad fact is that
today's Social Security promises younger workers much more in
retirement benefits that it can possibly hope to pay. Although the
program should be able to pay full benefits from its own cash flow
until about 2018, after that it will rely on increasingly larger
amounts of general revenue taxes to pay the promised benefits.
Initially, these amounts will be paid to retire the bonds in the
Social Security trust fund, with the annual amount of general
revenue needed to pay full benefits rising from approximately $20
billion in 2018 to over $600 billion by the time the last bond is
redeemed in about 2042.[15] After that, the existing law requires
Social Security to reduce its benefits to the amount that it can
pay using payroll taxes. After about 2042, that would require a 27
percent cut in benefit payments.

Despite promises from
both the left and the right to pay the promised benefits in full,
this is simply not realistic-in part because the benefit levels of
new retirees are increased each year beyond the rate of inflation.
While current retirees and those close to retirement should receive
every cent that they are due, future benefit promises must be
scaled back to more realistic levels.

At the same time that
benefits are becoming more realistic, it is essential that PRAs be
established to allow workers the opportunity to restore-and
even improve-their benefits through a carefully controlled
investment program. The combination of realistic
government-paid benefits and a PRA would be far more secure than
the current system of empty promises.

Ideally, aggregate
Social Security Part A benefits should be reduced gradually to a
level that could be sustained by the program's income. However,
this would have to take place over a substantial time so that
workers can adjust their retirement planning. In the interim,
Social Security's cash flow would have to be supplemented by
general revenues, but a reformed Social Security plan using PRAs
would cost substantially less than what the current system will
need to pay for its promises.

Changing How Social
Security Benefits Are Calculated. One of the reasons that
today's system will be unable to pay all of its promised retirement
benefits without substantial tax increases is the way benefits are
calculated. When retirement benefits are calculated, workers'
pre-retirement earnings are increased by both inflation and
the growth rate of wages across the entire economy. The total of
the two is higher than using an inflation index alone. As a result,
benefits for new retirees grow each year, even after adjusting for
inflation. In addition, retirees receive an annual cost-of-living
adjustment increase to reduce the effect of inflation on their
benefits.

One way to bring Social
Security's benefits into line with what it can afford to pay would
be to change how new retirees' benefits are calculated so that
their past earnings are increased only by the rate of inflation.[16] If
PRA earnings supplemented these results, workers would receive an
improved level of retirement income, which would generally be above
what today's Social Security could afford to pay. In addition, this
would sharply reduce the program's annual deficits.

Improved Benefits for
Lower-Income Workers. Another advantage of a
PRA system would be a minimum benefit that would protect all
workers from retiring into poverty after working a full career.
Because today's Social Security pays benefits based strictly
on past income, it is possible for the lowest-paid workers to work
a full career and then receive retirement benefits that are
significantly below the poverty level.

A PRA system should be
designed to pay these lowest-income workers a minimum benefit that
is atleast the poverty level, or perhaps even twice
the current poverty level.[17] These minimum benefits would be paid
through a combination of government-paid Social Security Part
A and PRA-financed Social Security Part B. In the event that the
combinations would still be below the designated minimum
benefit, the difference would be added to the government-paid
amount.

Benefits Calculation
Under a PRA System. The way that the two
parts of Social Security interact with each other is crucial.
Probably the simplest method would be to have Part A pay a monthly
amount based on workers' average earnings while they were working,
much as the current system does. To this amount would be added the
amount that could be paid through the PRA-funded Part B. If that
amount does not equal the system's minimum benefit, the
government would pay the difference by adding to the amount
paid by Part A.

Under a PRA system,
workers would have more control over their retirement options and
could choose not to take the full monthly benefit that could be
paid through the PRA. This would be allowed as long as the worker
chooses at least a certain minimum level of income so that he or
she does not become dependent upon government welfare payments for
daily living.

An alternate and
slightly more difficult way to calculate monthly benefits would be
to reduce the Part A benefits by a set amount based on either the
monthly income that could be generated by the PRA or the level of
contributions to the PRA plus some level of interest. Using this
method assumes a somewhat higher Part A base benefit than under the
preceding method. In this case, either the Part A benefit could be
offset by a proportion of the amount payable by the PRA, or the PRA
contributions could be assumed to grow by a certain annual
amount and the Part A benefit reduced by the result. If the
worker's account earned more than the assumed growth rate, he or
she would have either higher monthly benefits or a larger nest
egg.

An Alternative to Means
Testing. Establishing a PRA
system is far better than means testing as a way to keep the
program solvent. While both changes would reduce benefit costs
below what today's system has promised to pay future retirees,
means testing begins the process of turning Social Security into a
welfare program by denying benefits to workers with incomes
above a certain level, even though they have paid Social Security
taxes throughout their working lives.

Introducing PRAs would
allow Social Security to continue to provide benefits for workers
of all income levels. While upper-income retirees are much more
likely to have alternate sources of income other than Social
Security, as the system becomes unable to pay a higher and higher
proportion of benefits from payroll taxes, a means-tested
system would be forced to deny benefits to workers at lower and
lower income levels.

Changing to an
Appropriate Benefit Tax System. Contributions to PRAs
should be taxed in the same way that contributions to Roth IRAs and
similar retirement savings plans are taxed. Workers should pay
income taxes on the money that goes into their PRAs, but both the
growth of the account through interest and investment earnings and
all withdrawals should be tax-free.

This treatment sharply
contrasts with today's Social Security, under which workers pay
income taxes on contributions to Social Security and then pay
income taxes on up to 85 percent of their monthly benefits (if
their total retirement income exceeds $34,000 for single workers or
$44,000 for married retirees).[18] While the money raised
from this additional tax on certain benefits helps to fund both
Social Security and Medicare, it is also a form of means testing.
To make matters worse, because the income level subject to income
tax is not indexed to inflation, an increasing proportion of
retirees are subjected to this tax each year.

Improved Benefits for
Those Who Most Need Them. Some workers and their
families, particularly spouses who stay at home to raise
children and widows and widowers, are treated especially badly by
the current system's benefit structure. One of the goals of a PRA
system should be to improve benefits for these groups.

Spouses who remain at
home to raise children should not be penalized. Their benefits
could be enhanced through a combination of improved spousal
account options and including at least some of the years spent
raising children full-time in the benefit formula. Providing
generous incentives to families to continue to put money in the
spouse's PRA would pay large dividends. Because most families have
children at a fairly young age, that money would have the
opportunity to grow for some time and could significantly increase
the retirement benefits available to the stay-at-home spouse.
The increased spousal PRA could, in turn, reduce the amount of
benefits that spouse would receive through Part A.

Improving benefits for
surviving spouses who have no income other than Social Security
should be another priority. Today, widows and widowers often see
major reductions in their Social Security benefits after the death
of their spouses. Under current law, a surviving spouse's benefits
are usually between 50 percent and 67 percent of what the
couple received when both were alive. Surviving spouses should
receive at least 75 percent of the benefits the family received
when both spouses were alive. That seemingly small amount would
make a large difference in their standards of living.

Coordinating Retirement
and Disability Benefits. Currently, both Social
Security's retirement and survivors' program and its disability
program use the same benefit formula. That means that any benefit
changes in one program automatically affect the other. However,
these two programs are vastly different. One is essentially a
retirement savings program for older workers, and the other is
a straight insurance program that protects younger workers and
their families.

Therefore, when a PRA
system is established, Congress should create separate benefit
formulas for each program, preserving the current benefit formula
for the disability program and adjusting the retirement and
survivors' formula to allow for PRAs. This would allow disabled
workers to continue to receive the same benefits they receive
now. Once they reach retirement age, their benefits would be paid
through a combination of any funds available in their PRA and an
amount paid by the government. Retirement and disability benefit
amounts for older workers would be coordinated to reduce any
incentive to receive disability benefits instead of retirement
benefits.

Step #5: Create a
realistic plan for paying the general revenue cost of establishing
a PRA system.

Both the current Social
Security system and every plan to reform it will require
significant amounts of resources in addition to the money collected
through payroll taxes. This additional money, most likely from
general revenue taxes, is necessary to reduce the difference
between what Social Security currently owes and what it will be
able to pay. Under the reform plans, the transition cost represents
a major reduction in the unfunded liability of today's program.
Even though the reform plans are expensive, all of them require
significantly less additional money than today's Social
Security system.

Paying for either
today's Social Security or any of the reform plans will require
Congress to balance Social Security's needs against other
pressing needs such as paying for Medicare. In general, as
additional dollars are needed for either the current system or a
reform plan, fewer will be available for other government programs
and the private sector. As the annual amount required grows,
Congress will find it increasingly difficult to come up with the
money. Additionally, the longer that a plan needs large annual
amounts of additional money, the less likely that its benefits will
be paid on schedule. This is especially true for the current Social
Security system, which will need massive amounts of general revenue
funds for an extended period in order to pay all of the promised
benefits.

The necessary general
revenue will have to come from some combination of four sources:
borrowing additional money, increasing taxes, reducing
other government spending, and reducing Social Security benefits
more than is called for under current law or in the reform
plans.

Some plans attempt to
specify sources for the general revenues needed, but these are
handicapped by the fact that no Congress can bind the hands of
a succeeding Congress because the succeeding Congress could
change the plan at any time by a majority vote.

The most important
thing to remember is that both the existing Social Security system
and all known reform plans have this problem. This weakness is not
limited to personal retirement account plans or any other reform
plan. The only questions are when the cash-flow deficits begin and
how large they become.

Creating a Spending
Reduction Commission. Given the above
limitations, the best way to deal with either the cost of today's
system or the smaller amount required to establish a PRA system
would be to create a bipartisan spending reduction commission
modeled after the successful military base closing commissions. The
commission would examine federal programs to identify ones that are
wasteful and duplicate, do not accomplish their purposes, or simply
can no longer be afforded. It would then report its findings to
Congress as a legislative proposal to end, combine, or trim
specific programs.

Assuming that Congress
gives the spending reduction commission the same powers as the base
closing commissions, Congress would then have to consider the
report as a whole. Individual committees could examine spending
reductions that fall within their jurisdictions, but they would
have no authority to amend the proposal, and the entire package
would go to the House and Senate floors under an expedited
procedure that included an up-or-down vote. An alternative would be
to allow amendments, but only if each amendment reduces spending
enough to pay for the program that it seeks to preserve. Since, at
best, the Social Security deficits will persist for several
decades, a series of these commissions would be
necessary.

Borrowing.
Even under the
best of circumstances, some of the costs of either the current
Social Security system or a PRA system will likely have to be
handled through borrowing. If Congress acts responsibly to
reduce spending, borrowing may be necessary simply because
some deficits either are larger than expected or occur before they
were expected.

However, it would be a
serious error to attempt to cover all of the costs through
borrowing. This is especially true for the deficits that the
current system will begin to incur after about 2018. Not only
would the necessary amounts be huge (potentially several times that
of the existing federal Debt held by the public), but the annual
interest costs would rapidly grow to consume a major portion of the
federal budget. Debt should be used only to supplement a
transition plan, which should be funded mainly through spending
reductions.

Structuring Accounts to
Reduce Transition Costs. One way to reduce the
costs of establishing a PRA system would be to have the accounts
invest partly in U.S. government bonds. That way, a portion of
the money that moves between Social Security and the PRA would
move back to the government account, thus reducing cash-flow
deficits. This essentially requires the people who will
benefit the most from PRAs to bear a significant part of the cost
of establishing the system. In addition to reducing the cost
of PRAs, this investment structure also reduces the accounts' risk
level.

However, in order for
this structure to be more than a financial maneuver, the accounts
must be structured so that future generations not only repay the
bonds in earlier workers' accounts, but also require a smaller
proportion of them in their own accounts. For example, workers born
around 1990 might have 40 percent of their accounts in government
bonds, while those born in the 2010s would have only 38
percent.

Transition
Bonds. Another approach to the
costs of shifting to a PRA system would be to use transition bonds,
such as those used in Chile's reform during the early 1980s. In
this case, workers are given bonds that, when mature,
represent the retirement benefits they have already earned in the
current system. They are free either to deposit the bond in their
PRA or to sell it on the open market and deposit that money in
the account.

The bond effectively
cashes the individual out of the current system and bases his or
her benefits on the amount in that worker's PRA. The specific
budgetary consequences depend on when the bond matures, its
interest rate, and whether it is paid off in one lump sum (when the
worker reaches retirement age) or over time.

Raising taxes Must Be
Avoided. While some Congressmen
and Senators will be tempted to cover Social Security's deficits
with higher taxes, this is the wrong approach. For one thing, the
necessary amounts are so large that such a tax increase would
consume enough resources to stall economic growth. In
addition, workers already receive an extremely low return on their
taxes, and such a tax hike would only make matters
worse.

Step #6: Create a
system that allows workers flexibility in structuring their
retirement benefits while ensuring that they receive an
adequate monthly benefit.

Although the savings
portion of PRAs receives most of the attention, what happens after
an individual retires is equally important. A successful PRA
plan can give the worker the ability to tailor his or her
retirement income to meet specific goals. Today's Social Security
requires all workers to take the equivalent of a lifetime annuity
regardless of their health, needs, or financial
circumstances.

Annuitization.
In order to
protect both the retiree and the taxpayer, a PRA plan should
require all retirees to use some of their PRAs to purchase
annuities that would guarantee at least a minimal level of income
for life, including an adjustment for inflation. This requirement
would protect taxpayers against retirees who would otherwise
spend their entire PRAs and depend on some form of government
handout to meet their monthly expenses.

annuities would be
available from private companies through the central
administrative agency, as is currently done with the federal Thrift
Savings Plan. Workers could also buy them directly from companies
if the annuities meet certain financial safety standards. Companies
seeking to offer them would be required to have insurance or some
other safeguard that would allow the annuity to be paid even if the
company ran into financial difficulty. While today's annuities
have fairly high administrative costs, these are expected to
decline sharply once demand for the product becomes more
widespread. The central administrative agency would be able to
negotiate with providers to ensure that retirees are charged the
lowest fees possible.

However, workers need
not convert their entire PRAs into annuities. Ideally, a worker
would only be required to purchase a minimal-level annuity that,
combined with any government-paid benefit, would meet basic living
needs.[19] Of course, a worker could also choose to
purchase an annuity that pays a much higher benefit. Married
workers would have to purchase an annuity that included a spousal
benefit, which would continue to pay monthly income to the
surviving spouse.

Workers who chose a
minimal-level annuity could use a programmed withdrawal system
(similar to those available for today's IRA accounts) to
supplement their monthly income. As mentioned above, PRAs would be
designed to produce both retirement income and a nest egg that
could be used for emergencies during retirement, used to provide a
higher retirement income, or left as a legacy to the worker's
family. In addition, the worker could retire early if his or her
PRA was large enough to purchase an annuity that would pay the
minimal-level income for the rest of his or her life.

Conclusion

It is not fair either
to force senior citizens into poverty because of low Social
Security benefits or to beggar their children and grandchildren by
requiring them to pay for unrealistic promises. Establishing Social
Security PRAs is the one way that avoids both of these
extremes.

Because PRAs would earn
higher returns than the current 100 percent government-paid system
can afford to pay, they could preserve retirement benefits at a
sustainable level and also reduce the unfunded promises that future
generations will have to pay. However, they are not a magic bullet.
In order to work properly, a PRA system must be carefully
structured and administered. Whether reformed with PRAs or not, the
system must neither promise more than it can reasonably be
expected to deliver in benefits nor attempt to hide its true cost
through budget tricks.

The experience of over
25 countries shows that PRA systems can be structured to deliver
improved benefits in a cost-effective way. Rather than waiting for
the inevitable crisis to arrive, Congress should establish a Social
Security Part B that includes PRAs. Delay just makes the eventual
cost higher while denying younger workers increased control over
their own retirements and the ability to create nest eggs for their
families.

David C.
John is Research Fellow in Social Security and
Financial Institutions in the Thomas A. Roe Institute for Economic
Policy Studies at The Heritage Foundation.

[1]"Economic theory
and empirical evidence suggest that workers bear much of the
employer's portion of the payroll tax through lower wages and
reduced fringe benefits. If the employer-paid portion of payroll
tax receipts is counted as the contribution of the worker, roughly
80 percent of taxpayers pay more in payroll taxes than in income
taxes." The 80 per­cent figure includes payroll taxes for
Social Security Disability Insurance and a portion of Medicare in
addition to Social Security's retirement and survivors program.
Congressional Budget Office, Economic Stimulus: Evaluating
Proposed Changes in Tax Policy, January 2002, p. 12, footnote
7, at ftp.cbo.gov/32xx/doc3251/FiscalStimulus.pdf
(January 26, 2004).

[3]All taxes reduce
income and thereby reduce the ability to save or consume. Social
Security also reduces the incentive to save because it provides
retirement benefits that substitute for private savings. Virtually
all of the research in this area iden­tifies this "substitution
effect" as the source of Social Security's impact on savings. See
Congressional Budget Office, "Social Security and Private Saving: A
Review of the Empirical Evidence," CBO Memorandum, July
1998, at www.cbo.gov/ftpdocs/ 7xx/doc731/ssprisav.pdf
(November 15, 2004).

[5]These calculations
were made using The Heritage Foundation's Social Security
Calculator, at www.heritage.org/research/
features/socialsecurity. These values are consistent with the
calculations of the Government Accountability Office (for­merly
the General Accounting Office) and others. See U.S. General
Accounting Office, Social Security and Minorities:
Earn­ings, Disability Incidence, and Mortality Are Key Factors
That Influence Taxes Paid and Benefits Received, GAO-03-387,
April 2003, at www.gao.gov/new.items/d03387.pdf (November
15, 2004), and Lee Cohen, C. Eugene Steuerle, and Adam Carasso,
"Social Security Redistribution by Education, Race, and Income: How
Much and Why," paper prepared for the Third Annual Conference of
the Retirement Research Consortium on "Making Hard Choices About
Retirement," Washington, D.C., May 17-18, 2001, at
www.bc.edu/centers/crr/papers/Third/Cohen-Steuerle-Carasso_Paper.pdf
(November 15, 2004).

[7]It would be easier
to administer the PRA system if workers have only one opportunity
to opt out of it.

[8]Half of this amount
(5.3 percent) is deducted from the worker's paycheck, and the
employer pays the other half. As far as the employer is concerned,
the employer-paid share is really part of the worker's salary
because the tax is incurred for employing that particular worker.
In addition, other payroll taxes totaling 1.8 percent of wages pay
for Social Security's dis­ability program, and a further 2.9
percent pays for Medicare.

[9]The amount of
general revenues required would depend on the plan's design and the
extent to which it offsets future promised benefits.

[10]However, a recent
study suggests that the progressivity of the current Social
Security program is overstated and that lower-income workers
actually do worse than is popularly believed. For more details, see
Alan L. Gustman and Thomas L. Stein­meier, "How Effective Is
Redistribution Under the Social Security Benefit Formula?"
Journal of Public Economics, Vol. 82, No. 1 (October 2001),
pp. 1-28. An electronic version of an earlier draft is available at
www.dartmouth.edu/~agustman/ Redistr6.pdf (November 10,
2004).

[11]Calculated by the
Center for Data Analysis using data from Federal Reserve Board,
"2001 Survey of Consumer Finance," at
www.federalreserve.gov/pubs/oss/oss2/scfindex.html (February
17, 2003). In this analysis, any major inheritance, gift, or
bequest is considered an inheritance. Income figures represent
adjusted gross income.

[13]A similar
administrative structure was developed during the Clinton
Administration by experts from the Department of the Treasury and
the Social Security Administration. State Street Corporation also
developed this model independently in 1999.